Asymmetric Information in the Subprime Mortgage Market

Because of impersonal securitization in the secondary market, the ultimate investors in a mortgage have only a limited amount of information about the borrower's characteristics. This creates an asymmetric information problem because of hidden knowledge on the part of the primary lenders, who naturally have much better access to this information. This is aggravated by the free rider problem when there are multiple investors. We discuss to what extent the secondary market then seeks to sort the loans to ameliorate this problem and what role reputations play. More importantly, however, the actions of the primary lender in terms of which kinds of loans they choose to approve are partly hidden, and this typical principal-agent situation importantly aggravates the incentive problem. To judge the nature and magnitude of this moral hazard dilemma, we use data to compare how well investors in the secondary mortgage market can predict default given the information they typically have access to as compared to the ability of primary lenders to similarly predict default given the larger set of information they typically will have access to. Finally, the implications of these results are indicated, particularly in light of the recent mortgage crisis